Are Target Date/Life Cycle investments right for your CPF?

Are Target Date/Life Cycle investments right for your CPF?

Are Target Date/Life Cycle investments right for your CPF?

As we get older and inch closer to our retirement age, we intuitively understand that we are supposed to take less risk in our investments, shifting the focus from capital gains to income-generation with lower volatility

As we get older and inch closer to our retirement age, we intuitively understand that we are supposed to take less risk in our investments, shifting the focus from capital gains to income-generation with lower volatility

As we get older and inch closer to our retirement age, we intuitively understand that we are supposed to take less risk in our investments, shifting the focus from capital gains to income-generation with lower volatility

This sensible view has launched the idea of ‘Target Retirement Date’ funds, also called ‘Life Cycle’ investments.  While the details of these strategies differ, they share a major theme in common where exposure to growth assets (primarily equity as a proxy for risk) is gradually reduced as the investor ages, while exposure to stable assets (primarily bonds) is increased.

Singapore has appointed a CPF Advisory Panel which is currently exploring ways to improve the CPF scheme by implementing a Lifetime Retirement Investment Scheme (LRIS).  Part of this new scheme will be the likely introduction of Life Cycle funds as an option; while such implementation is still in the future, it is worth digging into the Life Cycle strategy in more detail so that investors fully understand what they may be buying.

The possible outperformance of a Life Cycle strategy vs. CPF guaranteed return rates or even a static-allocation balanced fund rests on some critical assumptions and the avoidance of some major risks; let’s analyse these assumptions using a number of scenarios.

Let’s take an initial simple assumption of a 30 year old who has saved SGD100,000 into their CPF.  Later on we will add regular contributions which mimic CPF more accurately to see how this changes the end result.  We take a long term expected annual return of 7% on equities and 3% on bonds.

At age 65, if our investor had allocated 100% of his pension in the Straits Times equity index will have grown 100,000 into 1.14 million, at 7% p.a. compounded.  A more balanced conservative strategy that allocates 50/50 to equities and bonds and rebalances annually would have grown to 716,000.  A Life Cycle fund that starts at in equities and allocates an increasing size to bonds every year, ending at 12% equities at age 65 would grow to 494,000.

So far, a Life Cycle strategy does not look that attractive, under the assumption of a straight line annual performance for the investments, something that only an academic researcher would use.  But it gets worse.

One of the major flaws of Life Cycle investments is if the investor experiences an equity bear market early on, when equity exposure is at the highest, it will wreak havoc on the end result at retirement. 

Assuming a sharp bear market where the first three years of investments produce equity performance of -10%, -10%, and then a final -15% for a total cumulative loss of -31%, the average of what a typical bear market looks like.  These losses are then made up with steady stronger performance in the following years, whereby our investor ends up with the same annualised return as the first example above. 

Using this second scenario, the investor who maintains 100% equity exposure ends with the same amount, 1.14 million, since the long term annualised return is the same.  On the conservative balanced strategy the end result is actually slightly better, at 718,000.  But on the Life Cycle it is much worse, at $398,000, a full -20% worse than the steady returns assumption.  The gap between these results and the balanced strategy widens even further, ending in a retirement nest egg that is -44% smaller.

One of the major flaws of Life Cycle investments is if the investor experiences an equity bear market early on, when equity exposure is at the highest, it will wreak havoc on the end result at retirement. 

Assuming a sharp bear market where the first three years of investments produce equity performance of -10%, -10%, and then a final -15% for a total cumulative loss of -31%, the average of what a typical bear market looks like.  These losses are then made up with steady stronger performance in the following years, whereby our investor ends up with the same annualised return as the first example above. 

Using this second scenario, the investor who maintains 100% equity exposure ends with the same amount, 1.14 million, since the long term annualised return is the same.  On the conservative balanced strategy the end result is actually slightly better, at 718,000.  But on the Life Cycle it is much worse, at $398,000, a full -20% worse than the steady returns assumption.  The gap between these results and the balanced strategy widens even further, ending in a retirement nest egg that is -44% smaller.

Let’s make the scenario more realistic with annual CPF contributions that start at 11,000 per year (916 per month) that grow at 6% p.a. (mirroring an annual increase in salary) until they are capped at 33,000 p.a. (2,750 per month).  Using the straight line returns with zero volatility, our investor ends with the following retirement amounts at age 65:

All Equity: 4.22 million

Balanced 50/50: 3 million

Life Cycle: 1.99 million

Something even more interesting happens if we repeat the initial bear market scenario followed by higher returns, coupled with annual contributions:

All Equity: 5.15 million

Balanced 50/50: 3.46 million

Life Cycle: 1.89 million

The first two strategies actually produce a higher end retirement sum despite the initial bear market, because at a time when contributions are high compared to the total CPF size, the investor keeps adding equities at lower prices each year, and benefits from the eventual normalisation and return to long-term average performance.  These strategies actually turn short-term volatility to the investors’ favour.  The Life Cycle strategy instead ends in a lower return.

Lastly, let’s illustrate the difference of the timing of equity performance on a retirement fund, assuming a CPF pension that stays invested in the Straits Times index for the full 35 years.  Taking the same 7% annualised long-term return, let’s make them more ‘lumpy’.  In the first example equity markets return 11% p.a. for the first half of the investors’ life, and drop to 4% p.a. for the second half.  In the second example, the returns are reversed (4% p.a. for the first half, 11% p.a. for the second).  The Compound Annual Growth Rate (CAGR) is exactly the same in both examples, at 7.66% p.a.

In the first example the same investor who starts with 100,000 and contributes every year ends with 4.02 million.  In the second example, he ends up with 5.97 million, a difference of almost 50%!

In taking account all of the above, we can make two major conclusions. 

First, in the early years of building one’s pension the level of contribution is far more important than the investment return earned on the pension.  This reverses as retirement approaches, where return on the investment is far more critical than the contribution.

The first two strategies actually produce a higher end retirement sum despite the initial bear market, because at a time when contributions are high compared to the total CPF size, the investor keeps adding equities at lower prices each year, and benefits from the eventual normalisation and return to long-term average performance.  These strategies actually turn short-term volatility to the investors’ favour.  The Life Cycle strategy instead ends in a lower return.

Lastly, let’s illustrate the difference of the timing of equity performance on a retirement fund, assuming a CPF pension that stays invested in the Straits Times index for the full 35 years.  Taking the same 7% annualised long-term return, let’s make them more ‘lumpy’.  In the first example equity markets return 11% p.a. for the first half of the investors’ life, and drop to 4% p.a. for the second half.  In the second example, the returns are reversed (4% p.a. for the first half, 11% p.a. for the second).  The Compound Annual Growth Rate (CAGR) is exactly the same in both examples, at 7.66% p.a.

In the first example the same investor who starts with 100,000 and contributes every year ends with 4.02 million.  In the second example, he ends up with 5.97 million, a difference of almost 50%!

In taking account all of the above, we can make two major conclusions. 

First, in the early years of building one’s pension the level of contribution is far more important than the investment return earned on the pension.  This reverses as retirement approaches, where return on the investment is far more critical than the contribution.

Second, the order in which returns are earned is the most critical factor to determining the end result at retirement.  An equity bear market that occurs early in a pension scheme has a big negative effect on Life Cycle strategies.  In fact each repeated bear market has a negative effect on Life Cycle strategies, as it causes equities to be reduced as the markets drop, whereas the correct strategy would be to buy more on lower prices.  With a 35 year horizon we can surely expect a few such bear markets.  A balanced strategy instead turns this volatility around and profits from it. 

The purpose of a pension investment plan should be to maximise the value of the pension at retirement, while at the same time also maximising the probability of arriving at the maximum value.  A constant all-equity strategy should theoretically maximise the end value of a pension, but will not maximise the probability of getting there, given that equities can (and do!) experience -30% or larger drops quite often.  Such a bear market occurring in the last few years of one’s retirement would have a devastating effect.  Consider the impact of an individual who was unlucky enough to retire in 1987, 1998, 2002, 2008, or after any of the large bear markets.

Conversely, if you’re 62 years old and equity valuations are near all-time historical lows, should you really be reducing exposure simply because retirement is three years away? 

Life Cycle strategies unfortunately do not maximise the value of a pension at retirement, and also run the significant risk of not maximising the probability of outperforming a guaranteed fixed CPF interest. 

Savers who had the bad luck of being 30 years old in 1999 and embarking on a Life Cycle strategy would have experienced a dismal pension return 16 years later, with the Straits Times index gaining 0.66% p.a. before dividends.  The investment strategy would have compounded the problem by regularly reducing exposure to equities even as valuations became cheaper.  Another saver who turned 30 in 2008 and started the same strategy would rejoice, earning 10% p.a. and having a high equity exposure during the strongest years of equity performance. 

Any investment strategy whereby the asset allocation does not take into account underlying valuations, expected returns and downside risk, may outperform in any one year due to luck, but is guaranteed to produce below average results over the long run.

Do not determine your CPF investment strategy solely on your age.  Markets do not care how old you are. 

By LEONARDO DRAGO

Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.